Month: October 2008

Schneier is shocked to find that people whose jobs are to handle other people’s personal data, actually take an interest in what they are doing.

Faulk says he and others in his section of the NSA facility at Fort Gordon routinely shared salacious or tantalizing phone calls that had been intercepted, alerting office mates to certain time codes of “cuts” that were available on each operator’s computer.

“Hey, check this out,” Faulk says he would be told, “there’s good phone sex or there’s some pillow talk, pull up this call, it’s really funny, go check it out. It would be some colonel making pillow talk and we would say, ‘Wow, this was crazy’,” Faulk told ABC News.

I’m sure anyone who’s worked for a telephone company, or an ISP, or a retail bank, finds that familiar. The information available is generally less interesting than actually hearing people’s phone conversations, but occasionally you get something worth mentioning – look at all the the sex-line calls on this bill, is this Fred Bloggs the Fred Bloggs that was on the telly, and so on.

If the personal information is more obviously sensitive, then there should be rules to limit how it is casually accessed. Of course, those rules will be broken from time to time – tax people are not supposed to investigate celebrities out of curiosity, here is a story from Britain, and one from the US. But in many cases it’s very much a grey area. A fraud investigator, say, or a programmer trying to track down a bug, would have more freedom to legitimately poke about where she wanted to than a call centre operator who would have little excuse to look up any information except on the calls received (although accidents can happen).

There will always be people whose access bypasses the checks – it is rare to have an in-house IT system that can work without the support staff being able to access the production system to fix it. The major regulatory/compliance effort within banks over the last five years or so has been restricting access to production data to fewer people, for the sake of Sarbanes-Oxley compliance, but it’s really hard to deny access to the people who write the software.

Now, the NSA ought to have very strong controls on access and use of information, with monitoring and spot checks and so on, but if the telephone interceptions are being carried on by the NSA in defiance of the law, it is hardly to be expected that appropriate rules will be applied to the staff.

Mr Mouse claims in a comment that widespread home ownership is undesirable. I would not go quite so far; there are benefits to home ownership – primarily the removal of the costly landlord-tenant relationship. Having said that, we are in agreement that the situation where the typical person’s investment portfolio consists solely of a highly leveraged bet on his local housing market is undesirable to the point of insanity. The point has been made widely, e.g. by Shiller.

But even if we accept a public policy aim of increasing home ownership, making it easier for people to borrow money is not the obvious way of going about it. If we want more people to own, say, smoke alarms, the way we do it is to make smoke alarms cheaper. Similarly, if a government decided, rightly or wrongly, that it would be better for more people to own houses, the obvious approach would be to make houses cheaper.

Headline of today’s London Evening Standard: “Worst House Prices Fall for 18 years“. I don’t remember reading recently about the “worst oil price fall” or “Worst computer price fall”. How is this?

The answer is obvious: once you have started down the road of encouraging home ownership by increasing borrowing, rather than by reducing prices, there is no turning back.

If I buy a computer, I don’t care what happens to its market value after I bought it. I will use it for 5-10 years then throw it in the bin. It is a physical asset, not a financial asset. If I borrow money to buy something, however, it is not just a physical asset. It is collateral. If I have been encouraged to get into this position, then undermined by a deliberate policy of devaluing the collateral, I will feel betrayed.

And so the process is continued. Interest rates are held down. The private sector’s lending standards are attacked. The supply of housing is deliberately restricted. After a while, it becomes obvious to everyone that a crash must come sooner or later. But even that is not enough to stop it. By that point, not only the government but also a large proportion of the population and a significant proportion of the financial industry is dependent on the bubble continuing – not for ever, as that is obviously impossible, but for long enough for “something to turn up” to save any individual participant. To someone looking to profit from the inevitable, the question is the usual one: “will the market stay irrational for longer than I can stay solvent?”, but with a coalition of politicians, swing voters, rich bankers and the construction industry devoted to keeping the market irrational, the question is even more pointed than usual.

In general, the higher the risk of an investment, the higher the expected return demanded by an investor. Readers familiar with the capital asset pricing model will know that there are two types of risk in the economy: systematic and nonsystematic. Nonsystematic risk should not be important to an investor. It can be almost completely eliminated by holding a well-diversified portfolio. An investor should not therefore require an higher expected return for bearing nonsystematic risk. Systematic risk, by contrast, cannot be diversified away. It arises from a correlation between returns from the investment and returns from the stock market as a whole. An investor generally requires a higher expected return than the risk-free interest rate for bearing positive amounts of systematic risk.

One quibble I have with a lot of the discussion of mortgage investments (such as this one, which I think is otherwise very good), is that it seems to offer a choice between two possibilities:

1) The current market prices of the securities correctly reflect their expected return

2) The securities are currently undervalued due to panic or other irrationality

I am fairly confident that neither of these positions is correct. Risk aversion is not irrational. If an investor loses more than he can afford to lose on one investment, that loss will itself cause secondary losses — if the investor is an institution, it might lose its credit rating, or go insolvent, causing some of its human and institutional capital to be impaired. Therefore, the expected utility of an risky investment is lower than its expected return.

As alluded to by Hull, in many cases much or all of the risk of an investment can be diversified away, leaving the extra risk premium small or zero. This is clearly not the case for mortgages. There is a possibility of a loss of somewhere on the order of a trillion dollars. No investor can absorb or hedge that. Many large investors — sovereign wealth funds, private equity, etc. -— have taken on stakes. Some are probably still looking for better prices than they’ve so far been offered. All will be looking for very substantial discounts against the expected return, because they know there are more sellers than buyers.

That is why I believe claims that this is a profit opportunity for the government.

That’s not the same as saying the government should be buying up mortgages at above current market value — there are other good arguments against it. But it holds up one piece of the argument, provided we assume that government is in fact better able to absorb the potential losses than private investors, which seems reasonable to me, though I can’t quite put my finger on a non-handwavy reason why.